Fed Raises Rates, Sets Sights on Balance Sheet

As expected, the Federal Reserve (the Fed) resumed its interest rate-normalization strategy, lifting the federal funds rate target 25 basis points at its latest monetary policy meeting. This move marks the central bank’s fourth rate hike since launching the tightening campaign in December 2015, when the overnight lending rate target range was 0% to 0.25%. Today, that rate sits at a range of 1.00% to 1.25%.

In its statement following the two-day meeting of the Federal Open Market Committee, the Fed cited modest year-to-date gains in economic activity, including jobs growth, household spending, and business fixed investment, as supportive of a rate hike. The Fed noted the risks to its economic outlook appear to be balanced, but indicated it is “monitoring inflation developments closely.” The Fed expects inflation, which recently dipped below the central bank’s 2% target, to stabilize over the medium term. The Fed also reiterated its commitment to gradually increasing the federal funds rate target.

Despite this latest rate hike, it’s important to note monetary policy still remains accommodative, which, according to the Fed, should support further strengthening in labor market conditions and a sustained return to 2% inflation.

Balance Sheet Reduction Next on Fed’s Normalization Campaign

The Fed’s post-meeting statement also indicated the central bank is set to begin reducing its $4.5 trillion balance sheet (its portfolio of Treasuries and mortgage-backed securities, or MBS). In the aftermath of the financial crisis, the Fed’s balance sheet swelled $3.7 trillion, as the Fed purchased Treasuries and MBS in a six-year effort to boost lending and support the financial markets (the program known as quantitative easing, or QE).

Although the Fed ended QE in 2014, it continues to reinvest all principal payments from its holdings back into the Treasury and MBS markets. This activity has provided continued support for the bond market—support that if ended abruptly potentially could drive interest rates sharply higher and derail economic growth.

The Fed’s plan would allow a set amount of maturities each month, beginning with $6 billion in Treasury securities and $4 billion in MBS. The net monthly maturities would increase every three months, eventually rising to a maximum of $30 billion in Treasuries and $20 billion in MBS.

As we expected, the Fed is pursuing balance sheet normalization the same way it’s seeking interest rate normalization—slowly, gradually, and transparently, so as not to disrupt the markets or the economic growth trajectory. Fed policymakers don’t want a repeat of 2013, when just the mention of a reduction in QE caused U.S. Treasury yields to spike. Since then, the Fed has been telegraphing its intents and targets regularly and more clearly.

Another Slow and Steady Strategy

According to the Fed’s post-meeting statement, the central bank “currently expects to begin implementing a balance sheet normalization program this year, provided that the economy evolves broadly as anticipated.” However, in the addendum to the statement, the Fed was more vague, noting balance sheet reduction will begin when “normalization of the level of the federal funds rate is well under way.” We believe it’s possible the next Fed “tightening” may be a balance sheet announcement.

Fed’s Approach Shouldn’t Trigger Big Sell-Off

The Fed wants and needs to further normalize its rate target after it’s been so low for so long. Similarly, the central bank also needs to reduce its balance sheet, which is at a record high.

Given the Fed’s commitment to transparency, and the current economic climate, we do not expect near-term moves from the Fed to trigger a significant bond market sell-off. While short-maturity interest rates are directly influenced by Fed actions, longer-maturity rates and yields are more market driven. Supply and demand for bonds, geopolitical uncertainties, and expectations for inflation and economic growth are key factors influencing the direction of longer-maturity rates. In the near term, we believe expectations for economic growth and inflation, influenced largely by the success or failure of President Trump’s tax and regulatory reform and fiscal spending proposals, will be the main drivers of longer-maturity rate moves.

Market conditions have kept longer-maturity U.S. Treasury yields range-bound so far this year, as expectations for stronger growth and higher inflation have moderated. Investors initially expected President Trump’s pro-growth policies would usher in stronger growth and higher inflation in 2017. But much of the president’s agenda remains stalled, which is helping to keep a lid on longer-maturity rates. We expect the 10-year Treasury yield to remain in a range of 2.10% to 3.10% for the next 12 months, barring any big surprises in U.S. or global economic conditions.

Dave MacEwen is co-chief investment officer at American Century Investments. He shares responsibility for overseeing the discipline CIOs and investment teams that manage client assets across the firm. An avid sailor, Dave competes in an annual Pacific trip between California and Hawaii.

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